Cambridge A Level Economics: Controlling inflation, demand for money and interest rate determination (9708)

This guide follows the Cambridge International AS and A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. It covers outcomes 9.4.6, 9.4.7 and 9.4.8 of section 9.4 (Money and banking). Topic 9 is A Level content, so none of this is examined at AS. AS content on inflation (4.6), monetary policy (5.3) and supply-side policy (5.4) is assumed knowledge. All countries and figures below are invented and illustrative, and money is in currency units (cu).

Other pages: the revision notes, the practice set, the course hub, the checklist and the free 10-minute diagnostics. For the AS background, see monetary policy and supply-side policy, fiscal policy and floating exchange rates.

What this guide covers

Outcome	What you must be able to do
9.4.6	Explain policies to reduce inflation and assess how effective they are
9.4.7	Explain the demand for money using liquidity preference theory
9.4.8	Explain interest rate determination using loanable funds theory and Keynesian theory

9.4.6 Policies to reduce inflation and their effectiveness

The syllabus does not list particular policies, so choose from the three AS families and match the policy to the cause. Inflation means a sustained rise in the general price level. The AS content separates demand-pull inflation (AD growing faster than the economy’s capacity) from cost-push inflation (rising unit costs shifting short-run aggregate supply, SRAS, to the left).

Demand-side policies

These aim to shift aggregate demand (AD) to the left, or slow its growth.

• Contractionary fiscal policy: the government cuts spending or raises taxes. A smaller injection, or lower disposable income, reduces consumption and AD, and the multiplier magnifies the effect.
• Contractionary monetary policy: the central bank raises its policy interest rate, slows money supply growth or tightens credit regulations. Dearer borrowing cuts investment and durable consumption, and saving becomes more rewarding.

Worked example 1 (fiscal). Country A has a marginal propensity to withdraw of 0.4, so the multiplier is 1 ÷ 0.4 = 2.5. The government cuts spending by 8 cu. The fall in AD is 8 × 2.5 = 20 cu. Suppose the price index was 100 in 2025, 106.0 in 2026 and 110.24 in 2027, so inflation fell from 6.0% to 4.0%. The chain is: lower spending, AD shifts left by 20 cu, the price level rises more slowly, and output growth slows too.

Worked example 2 (monetary). The central bank of Country A raises its policy rate by 2 percentage points. Suppose each 1 percentage point rise cuts investment by 3 cu. Investment falls by 2 × 3 = 6 cu, and with the multiplier of 2.5 the fall in AD is 6 × 2.5 = 15 cu. Real interest rates matter for decisions. With inflation at 5% a policy rate of 4% gives a real rate of 4 − 5 = −1%, and a rate of 7% gives 7 − 5 = +2%. Policy has moved from loose to tight even though the starting rate looked positive.

Supply-side policies

These raise productivity or reduce costs, shifting long-run aggregate supply (LRAS), and SRAS, to the right. Examples are training, infrastructure and support for technology. The price level falls relative to what it would have been while real output rises, so inflation is reduced without the output loss of a demand squeeze.

Exchange rate appreciation

A government or central bank may allow or encourage a stronger currency. Imported inputs and goods become cheaper in domestic currency, which lowers costs and prices. Exports become dearer and imports cheaper, so net exports fall and AD shifts left.

Worked example 3. Country A buys a raw material priced at 40 foreign units (fu). At an exchange rate of 0.80 fu per cu the cost is 40 ÷ 0.80 = 50 cu. The currency appreciates to 0.90 fu per cu (an appreciation of 12.5%). The cost becomes 40 ÷ 0.90 = 44.44 cu, a fall of 11.1%.

Worked example 4 (why cost-push differs). Wages rise 5% while output per worker rises 2%. Unit labour costs rise by 1.05 ÷ 1.02 − 1 = 2.94%. Cutting AD would not remove this pressure, and raising productivity would.

Evaluating effectiveness

Build your evaluation from these links, and say which matter most in the case you are given.

1. The cause. Demand management works best on demand-pull inflation. Against cost-push inflation, a fall in AD cuts output and employment while prices fall slowly.
2. Spare capacity and the shape of AS. If the economy is near full capacity (a steep SRAS), a leftward shift of AD cuts the price level a lot and output a little. If there is spare capacity (a flat SRAS), the same shift cuts output and employment and the price level barely moves.
3. Time lags. Interest rate changes take time to affect spending. Fiscal changes need legislation. Supply-side policies take longest. The policy may take effect after the inflation has passed.
4. Size of the multiplier and interest sensitivity. Where households are heavily indebted at variable rates, a rate rise bites hard. Where investment depends on expected sales and not on borrowing costs, it bites less.
5. Side effects and conflicts. Slower growth, higher unemployment, a weaker budget position and, for a strong currency, damage to exporters.
6. Expectations and credibility. If households and firms believe the policy will work, wage and price setting adjusts down and the policy is cheaper. Without credibility, inflationary expectations persist.
7. Global factors. A government cannot control imported cost-push inflation caused by world prices.

9.4.7 Demand for money: liquidity preference theory

Liquidity preference theory is Keynes’s explanation of why people hold money (the most liquid asset, which earns little or no interest) and not interest-earning assets. There are three motives.

• Transactions demand: money held to pay for everyday purchases. It rises with income and with the price level.
• Precautionary demand: money held for unexpected needs. It also rises with income.
• Speculative demand: money held in order to avoid capital losses on bonds. It falls as the interest rate rises.

The first two are treated as depending mainly on income, so they shift the total demand curve. Only the speculative motive gives the downward slope.

Bond prices and the speculative motive

A bond pays a fixed annual sum (the coupon). Its market price moves inversely to the market interest rate. For a bond that pays a coupon for ever, price = coupon ÷ interest rate.

Worked example 5. A bond pays 6 cu a year.

Market interest rate	Price (6 ÷ rate)
5%	120 cu
8%	75 cu
4%	150 cu

Someone who buys at 75 cu when the rate is 8% and sells at 120 cu after the rate falls to 5% gains 45 cu, which is 60% of the purchase price. Someone who holds at 120 cu when the rate rises to 8% loses 45 cu, a 37.5% fall.

The argument runs as follows. When rates are high, bond prices are low and many people expect rates to fall and prices to rise, so they buy bonds and hold little speculative money. When rates are low, bond prices are high, many expect rates to rise and prices to fall, so they hold money. Hence the demand for money curve (L) slopes downward against the interest rate.

Shifts and the liquidity trap

• A rise in national income or the price level shifts the demand curve for money to the right at every rate. A fall shifts it left.
• At a very low interest rate, bond prices are so high that nearly everyone expects a fall and prefers money. The demand curve becomes horizontal, which is the liquidity trap. Extra money supply is then held and not spent, so the rate stops falling.

9.4.8 Interest rate determination

Loanable funds theory

The interest rate is the price of borrowing. It is set where the demand for loanable funds equals the supply.

• Demand comes from firms (investment), households (borrowing for consumption and housing) and the government (a budget deficit). It falls as the rate rises.
• Supply comes from saving by households and firms, and from foreign savers. It rises as the rate rises.

Worked example 6. Demand is 90 − 6r and supply is 10 + 4r, in billions of cu, with r in percent. Setting them equal: 90 − 6r = 10 + 4r, so 80 = 10r and r = 8%. The quantity is 90 − 48 = 42, and supply gives 10 + 32 = 42.

• A government deficit adds 20 to demand: 110 − 6r = 10 + 4r, so r = 10% and the quantity is 50. This is crowding out, because higher rates reduce private borrowing.
• Saving rises by 10 at every rate (supply 20 + 4r): 90 − 6r = 20 + 4r, so r = 7% and the quantity is 48.

Keynesian theory

In the Keynesian view the interest rate is set in the money market. The central bank fixes the money supply (Ms, a vertical line) and the demand for money (L) is the liquidity preference curve.

Worked example 7. Demand for money is 170 − 10r and Ms is 100. Then 170 − 10r = 100 gives r = 7%.

Change	New equilibrium
Ms rises to 120	170 − 10r = 120, so r = 5%
Ms falls to 80	r = 9%
Income rises (demand 200 − 10r), Ms 100	r = 10%

A lower rate raises investment and AD through the multiplier. In a liquidity trap the transmission breaks down, so monetary expansion has little effect.

Comparing the theories

	Loanable funds	Keynesian
Interest rate is the price of	borrowing and lending (flows of saving and investment)	holding money (a stock)
Main drivers	saving, investment, government borrowing	money supply, liquidity preference
A rise in saving	shifts supply right and lowers the rate	does not set the rate directly
Policy emphasis	fiscal deficits and saving	central bank control of money supply

Evaluation: the theories can be combined, as the money market and the market for funds both operate. In practice many central banks set a short-term policy rate directly and supply whatever money is demanded at that rate, so the money supply is not always a fixed vertical line. There is also a range of rates and not one rate, and expectations about inflation and risk move all of them.

Common errors

• Describing a contractionary policy with the wrong direction of AD shift.
• Using one policy for every cause of inflation. Fiscal restraint is a weak answer to a cost shock.
• Mixing up the bond price and the interest rate: they move in opposite directions.
• Treating the money supply as a stock that moves with the interest rate. In the Keynesian model it is fixed by the central bank.
• Using nominal rates where the real rate drives behaviour.
• Giving a list of policies with no judgement about which is most effective in the stated case.

Official syllabus

Cambridge International AS & A Level Economics 9708, syllabus for examination in 2026, 2027 and 2028, published by Cambridge University Press & Assessment (Cambridge International Education), section 9.4, outcomes 9.4.6 to 9.4.8. Topic 9 is A Level content.